The two main heads in income are net interest income which is earned from lending activities. As I explained also in the last article, the bank pays customers interest on their deposits and it earns interest on the loans it extends to borrowers. The difference between the interest earned and interest expense is the net interest income or NII.

Fee income is earned from loan processing fees, transaction fees, credit card fees and service charges. Think of the recent SMS alerts for which banks have started charging customers. If you want an attested printed account statement some banks charge you a small fee. All these items add up to the fee income for a bank.

Net interest margin and interest spread

Again, I take figures from the ICICI Bank Annual Report for FY2013.

Figures are in Rs. bn

Fiscal 2012

Fiscal 2013

% change

Interest income

335.42

400.75

19.50%

Interest expense

228.08

262.09

14.9

Net interest income

107.34

138.66

29.2

Average interest-earning assets

3,932.59

4,465.40

13.5

Average interest-bearing liabilities

3,603.51

4,073.47

13.00%

Net interest margin

2.73%

3.11%

NA

Average yield

8.53%

8.97%

NA

Average cost of funds

6.33%

6.43%

NA

Interest spread

2.20%

2.54%

NA

Net interest margin is a parameter that is of great interest to a bank stock investor. It is the net interest income divided by the interest earning assets.

NIM tells you about the profitability of the core lending business of the bank. Here I will ask you to link your knowledge of CASA from the previous article.

It is evident that the higher the proportion of CASA deposits in the total deposits, the lower will be the interest expense. A bank can choose to lend at attractive rates (lower than competitors) and still maintain a healthy NIM if its interest expenses paid to depositors are low.

This is one lever.

Another lever is the interest earned. Now, this is a tricky subject. A bank can earn more interest on a loan by charging more than the market. But why will a borrower pay up a relatively high interest rate?

Possibly, if other banks refuse to lend to it. Why would they not lend to it?

Maybe it is a risky proposition to begin with. Maybe, the other banks do not have strong credit teams or understanding of the borrower’s situation. They possibly are not good at structuring a loan’s terms and conditions and the amount and type of security they take from the borrower.

Contrary to this, a bank may be able to do exactly the opposite. They can contain the risk through innovative structuring or by taking adequate security, they can take this business which others have rejected. They can earn a high interest rate on loans which others are not in a position to make. This will give them a relatively high NIM even with roughly the same cost of funding as other banks.

Needless to say, this entails higher risk of things going wrong. It is a fine line that the bank must then walk.

Spread is a slightly different way to look a the interest numbers.

Divide interest income by interest earning assets (335 /3932). This works out to 8.53%.

The difference between the two figures is 2.20% which is the interest spread.

Fee income to operating income

Think of your interactions with a bank. We might not buy boilers from BHEL or steel from Tata Steel but each of is a customer of some or the other bank. It is easy to understand that over the years, fee income is only rising for banks for retail customers. For starters, a decade ago, banks were supposed to be boring and staid. Most banks from the public sector hardly cared about customers. Private banks entered the scene and changed the rules of the game. Features like multi-branch banking, internet banking, and credit cards were not as widely used as they are today. Banks have more interactions with customers across multiple banking product lines and services that enable them to earn more in the form of fees.

This is a parameter that many analysts track since fee income has been seen to grow at a fast clip in most banks as compared to the “traditional” net interest income.

In ICICI Bank’s case, the fee income to operating income (69.01 divided by 222.12) is 37%.

The net interest income to operating income (138.66 divided by 222.12) is 59%.

Operating expenses and cost to income

The biggest operating expense is usually salaries to employees. For example, in ICICI Bank’s Rs. 90 bn operating expense, Rs. 38 bn is towards employees. Other big expense heads are Rent, taxes and lighting at around Rs. 7 bn and repairs and maintenance at around Rs. 7 bn.

The cost to income ratio is the ratio of operating expenses to the net operating income. For example in FY13, the operating expenses (Rs. 90 bn) divided by the net operating income (Rs. 222 bn) yield a cost to income ratio of 40%. In the earlier year this was around 43%.

ICICI Bank has one of the better cost to income ratios seen among Indian banks.

As an investor, you want the cost to income ratio to be declining over time. This would signal efficiency in operations. It means that the banks is spending less on operations relatively to do more business (lending + fee income).

Provisions

This is another important metric to track. This assumes much more importance especially in times of economic stress when bad loans start rising.

Provisions are mandatory as per RBI guidelines. They force the bank to keep aside some of their income even if all is good (provisions on standard assets). They also force the bank to recognize bad loans and deduct appropriate amounts when there are signs that loans are going bad or have gone bad (provisions on substandard assets and NPAs).

The better the credit process, the better will be the quality of the loan book. In bad times, lesser loans will go bad. Correspondingly, lesser provisions will need to be deducted from income.

Reading material

The RBI website is the base for any serious understanding of bank financial statements and analysis.

I recommend reading the RBI master circular given below. This will explain how assets are classified on a bank’s balance sheet. This will tell you more about NPAs and how a bank is supposed to make provisions towards advances or loans (both good or bad).